Tax Considerations of Collaboration Arrangements in the Life Sciences Sector
Life science entities continue to adjust to transformative changes and are increasingly pursuing collaborations with third parties to develop or commercialize promising drugs, new medical devices, or other technologies in an effort to share in both the costs and risks associated with such activities. The coronavirus pandemic has created a new urgency in the life sciences sector, and recent headlines are filled with announcements of collaborative deal structures in the race for a COVID-19 vaccine, diagnostics (e.g., rapid tests), and treatments.
While free-flowing collaboration and focused innovation have long been lofty ideals of biotech and pharma companies, because of the COVID-19 pandemic, they’re now imperatives to doing business. With new mandates come new funding pressures, a need to get even tougher on pipeline decisions, and a heightened risk environment.
General Background on Collaborations
Although collaborations can take various forms, in a typical model, a development-stage life science company exclusively licenses or sells intellectual property rights to an unrelated, mature life science company in exchange for upfront fees (or shares of profits), milestone payments, royalties, and/or equity investments. Collaboration agreements generally allocate rights and responsibilities between the parties for joint development, clinical trials, regulatory compliance, manufacturing, promotion, and commercialization. These arrangements may be documented in an asset purchase agreement, licensing agreement, alliance agreement, development agreement, co-marketing agreement, or other formal agreement between the parties.
Collaborative agreements generally provide for three types of payments: (1) a non-refundable upfront payment at the agreement is concluded, (2) a milestone or installment payment, contingent on research or other specified accomplishments, and (3) royalties for commercialization.
To determine the proper tax treatment of these payments, several issues must be addressed:
Partnership or Contract?
One threshold issue is whether the collaboration should be characterized as a partnership or as a contractual arrangement. There have been instances where collaborative arrangements have been characterized by the Internal Revenue Service as partnerships if certain hallmarks are present. In general, a contractual arrangement may be recharacterized as a partnership if the participants carry on a trade or business, financial operation or venture, and share in the resulting profits and losses. A joint undertaking merely to share expenses does not create a partnership for federal income tax purposes.
The determination of whether an arrangement is a partnership or a contract depends on the facts and circumstances of the particular agreement. Courts have articulated several factors that should be taken into account in determining whether an arrangement should be characterized as a partnership for tax purposes.
Recharacterization of a contractual collaboration as a partnership can have some unintended tax consequences, including: (1) the economics of the deal concluded by the parties may differ from what was planned originally, (2) collaboration payments may not be treated as income or expenses, but rather as partnership contributions and distributions, (3) different tax reporting requirements (a new entity would be formed, necessitating a Form 1065, Partnership Return of Income filing) and (4) tax accounting methods would be made at the partnership level returns rather than those made by the parties.
A best practice would be to examine the terms of collaboration agreements to confirm the desired tax characterization, ensure the intentions of the agreement are in line with the expectations of the parties and that the intended tax consequences are achieved.
Sale or License?
Another tax issue that can arise in the context of collaboration arrangements is whether a transfer of intellectual property should be considered a sale of an intangible or a license to use intangible property. Generally, a sale occurs for tax purposes when “all substantial rights” to the property have been relinquished, whereas a licensing arrangement exists when the person transferring the right retains control (e.g., over major decisions related to the intellectual property) or a significant interest.
One of the most significant differences between a license and a sale transaction is that sale proceeds are taxed as capital gains, whereas license payments are taxed as ordinary income. For a corporate taxpayer, capital gains and ordinary income are currently taxed at the same federal income tax rate. However, the characterization as capital gains or ordinary income is meaningful where a corporation has capital losses, and the ability to utilize those losses might be limited without the recognition of capital gains. Under Internal Revenue Code Section 1211, a corporation’s net capital losses may be offset only to the extent of capital gains in that year. Further, any unused capital losses can be carried back to each of the three prior taxable years and carried forward for five taxable years under Section 1212. Accordingly, the determination of where there is a license versus a sale may be decisive as to whether a taxpayer can use tax attributes or whether they will expire unused. The determination will also affect the timing of income recognition, including whether any income tax deferral opportunities exist.
At the same time, the license versus sale determination will impact the timing of the tax deduction—for both the licensee or the buyer. In the case of a license, the licensee’s payments are generally deductible as the requirements of Section 461 are met, ratably over the term of the license. On the other hand, the buyer’s tax treatment of the payment would likely result in the creation of asset basis, which may be amortizable under either Section 167 (over the license term or the life of the patent) or Section 197 (over 15 years or the remainder of the 15 years once incurred). Similarly, income recognition under Section 451 may be impacted by the determination for the licensor or seller of the intellectual property. The timing of income will depend not only on the character of the transaction, but also on the timing of when cash is received, in addition to when the revenue is recognized for financial reporting purposes (in certain cases).
- Consider whether the collaboration should be structured as a purchase or license of intellectual property.
- Ascertain whether it is possible to defer any upfront payments under Section 451(c), which provides for a one-year deferral of income.
- Evaluate the tax accounting methods accorded to the payments—whether such amounts are deductible or capitalizable (and, if capitalizable, the period of time over which they may be amortized), when these payments should be recognized into income, and whether any potential deferral of income or accelerated deduction opportunities exist.
R&D – Which Party Benefits?
Issues can arise as to which party to a collaboration arrangement is entitled to research and development (R&D) tax benefits. The prevailing view is that the payer of upfront fees and milestone payments is generally not entitled to R&D benefits, principally because the technological risk (necessary to qualify for the benefits) remains with the developer, nor do royalty payments qualify for R&D benefits because such payments are made only when the product is approved for sale and commercialized, at which time all of the technological risks have been overcome.
Allocating R&D tax benefits is important because these benefits are not equally useful to both parties. In the majority of cases, the developer is usually in the pre-revenue stage, with substantial net operating losses (NOLs), and thus claiming R&D tax credits are of reduced benefit. Thus, any Section 174 deductions for research and experimental expenses or as expenses used in calculating a Section 41 credit for qualified research expenses would provide a greater benefit to the recipient of the intellectual property.
The various payments in a collaboration arrangement are designed to coincide with specific stages of product development. For example, upfront payments are typically made at the time the collaboration agreement is signed and, importantly, are not contingent on the successful completion of research. Upfront payments represent payments for research that is already completed at the time the payment is made, and thus there is no technological risk to the payer at that point. Accordingly, the payer is not likely to be entitled to a Section 174 deduction (or the Section 41 credit). However, the developer may be able to claim an R&D benefit.
Milestone payments become due following a “triggering” event (e.g., FDA approval) and are designed to compensate the developer for the increase in value of the intellectual property. However, the developer still bears the technological risk for all expenditures incurred before the milestone payment is received and is likely entitled to a Section 174 deduction or Section 41 credit.
Finally, royalty payments are due once the product is approved for sale. At this point, there is no longer any technological risk, only marketing, and commercial risk.
Recipients of payments under a collaboration agreement should review the terms of the agreement to ensure that they are including the appropriate amounts in their Section 174 deduction and Section 41 credit calculations.
Some key areas that life science companies should consider in the context of collaboration agreements include the following:
- Financial Statement Reporting - ASC 808, Collaborative Agreements, does not provide specific recognition or measurement guidance on the accounting for a transaction between participants of a collaborative arrangement. Due to the lack of authoritative guidance, the manner of accounting for these transactions can be diverse in practice. Implementation of ASC 606, Revenue from Contracts with Customers, led to uncertainty as to whether a collaborative arrangement should be accounted for pursuant to ASC 606, or to other guidance. In November 2018, the Financial Accounting Standards Board issued ASU 2018-18 to clarify the interaction between ASC 808 and ASC 606.
- ASC 740 Income Tax Accounting – Once the proper tax and accounting treatments for collaboration agreements are determined, companies will need to consider the appropriate income tax accounting. Among other considerations, the recognition of deferred tax assets would need to be assessed for realizability as part of a company’s overall valuation allowance determination. In addition, companies would need to consider whether any uncertain tax positions exist that may be necessary to record under ASC 740-10.
- Net Operating Loss Utilization – Collaboration agreements may provide a source of revenue for companies that are historically in loss-making positions. This may allow for the utilization of existing NOLs to offset a portion of the income, subject to certain limitations. In addition to the applicable limitations on the utilization of NOLs, companies will need to determine whether there is a limitation on the ability to utilize NOLs due to an “ownership change” as determined under Section 382.
- Election to Treat R&D Credit as Payroll Tax Credit – Certain eligible entities that may not otherwise be able to benefit currently from R&D credits that they generate may be able to benefit from the credits as offsets to payroll taxes.
- Jurisdictional Taxes Issues – Additional benefits may be available in the form of incentives or credits depending on the company’s global and domestic footprint. Likewise, a company may face additional direct and indirect (e.g. customs, VAT) tax compliance burdens.
Life science companies contemplating and entering collaboration agreements will benefit from a thorough advance tax analysis. Unforeseen and costly compliance burdens can be avoided, and tax positions optimized when such considerations are addressed throughout the stages of the deal—from planning to filing. Determining whether a collaboration results in a partnership when intended to be solely a contractual relationship or whether the terms of the agreement result in a sale or a license of property (tangible or intangible) are examples of the types of preliminary tax analysis required by all parties to an agreement. The attractive incentives, such as the R&D credit and who is entitled to claim them in these arrangements, will follow accordingly in the analysis.